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Cyprus

Natasha Pilides
PwC
Cyprus

Whether companies are looking to centralise their treasury operations or simply to structure a single financing transaction in a way that minimises their tax cost, Cyprus offers a number of interesting, explains Natasha Pilides of PwC

As the pressure is rising on corporations of varying sizes to cut costs and emerge from the financial downturn in as solid a shape as possible, the question of tax efficient financing once again comes to the forefront. Whether companies are looking to centralise their treasury operations or simply to structure a single financing transaction in a way that minimises their tax cost, Cyprus offers a number of interesting alternatives.

Since becoming a full member of the EU in 2004, Cyprus has enhanced its position as a reputable international financial centre and has been on the white list of all relevant international organisations, including the list published by the OECD after the April 2009 G20 summit. Cyprus boasts a plentiful supply of highly qualified professionals and extensive experience in providing tax, accounting, administrative and consulting services to investors from all over the world.

As a former British colony, Cyprus has a UK-based legal system and English is used as the main business language. The island's location, its extensive double tax treaty network and the applicability of all EU Directives offer access to a number of different markets not just within the EU, but in Central and Eastern Europe, China, India and the US.

Tax advantages relevant to financing activities

For many years, Cyprus has been widely used as a financing company location, largely because of the number of tax benefits it combines, which include the following:

• Low corporation tax rate of 10% (lowest in the EU);
• No imposition of withholding tax on interest/ dividends/ royalties paid out;
• Wide-ranging tax exemptions including:
• Unconditional exemption on profits from share disposals;
• Exemption on dividends from foreign subsidiaries;
• Exemption on profits of foreign permanent establishments;
• Liberal deductibility of expenses;
• Unilateral relief of any foreign tax suffered;
• No thin capitalisation rules;
• Extensive double tax treaty network (with over 40 countries), reducing withholding taxes on interest income at the source country;
• Applicability of all EU directives. Interest and Royalties Directive applies as from May 1 2004 therefore eliminating withholding taxes on payments from other EU associated companies (subject to the relevant directive conditions).

Structures traditionally used in arranging back-to-back financing activities through Cyprus can ensure access to all the above benefits, as well as potential interest expense deductibility in the borrower's jurisdiction (see Diagram 1).

Diagram 1: Basic structure

Here, the parent, located in or outside the EU or in a favourable tax jurisdiction (FTJ), establishes a Cypriot company which it finances through equity. The Cypriot company then provides a loan to its EU/ Indian/ CEE subsidiary. Benefits include:

• Low or no withholding tax on interest payments because of the applicability of a favourable Cyprus double tax treaty or EU Directives;
• Potential deductibility of interest expense in the borrowing company;
• 10% tax on interest income in Cyprus following deduction of business-related expenses, direct or indirect;
• No withholding tax on dividends paid from Cyprus at all times;
• Potential participation exemption on dividend income in the parent company's jurisdiction;
• No tax in Cyprus upon disposal of shares in the subsidiary.

Other options

Other than the basic structure indicated in Diagram 1, there are additional tax efficient structures which may be used, an example of which is the set-up of a Cypriot company with a Swiss finance branch, as indicated in Diagram 2.

Diagram 2: Cypriot company with Swiss finance branch

In Diagram 2, the double tax treaty applying should be that between the borrower's jurisdiction and Cyprus ( for example very favourable double tax treaties with Russia, Ukraine, India). Therefore, by implementing such a structure, groups could gain access to the following tax advantages:

• No or low withholding tax on interest payments to the Swiss finance branch
• No tax on interest income in Cyprus because of the tax exemption on income earned by a foreign permanent establishment of a Cypriot company
• Potential deductibility of interest expense in the borrowing company
• No withholding tax on dividend payments from Cyprus at all times
• Potential participation exemption on dividend income in the parent company's jurisdiction

Such a financing set-up would also work with the use of a Cypriot company holding an Irish branch. In such a case, interest income received by the Irish branch would in fact be totally exempt from Irish tax, provided a single loan facility is involved.

Although structures like these have been widely used in the past, perhaps the most popular option chosen by investors involving Cypriot financing companies is the use of a Cypriot company for back-to-back financing, as illustrated in Diagram 3.

Diagram 3: Back to back structure

In this back-to-back financing structure, a company located in a favourable tax jurisdiction establishes a Cypriot company which it finances by means of a loan. The Cypriot company then on-lends to its EU/non-EU operating subsidiary. Again, the structure provides access to a number of tax benefits including the following:

• Low or no withholding tax on interest payments because of the applicability of a favourable Cyprus double tax treaty or EU directives
• Potential deductibility of interest expense in the borrowing company
• 10% tax on thin interest spread in Cyprus (see below)
• No withholding tax on interest payments from Cyprus at all times
• No tax in Cyprus upon disposal of shares in the subsidiary

Thin interest spreads on related party financing

Recent developments regarding the tax authorities' position on back-to-back loans further enhance the competitiveness of Cypriot financing companies by providing certainty regarding related party loans.

In particular, the Commissioner of Income Tax in Cyprus has recently formally accepted specific minimum spreads on related party financing transactions. These spreads provide additional comfort to the rather generic arm's length article of the legislation, which simply states that transactions between related parties should be carried out under terms no different from those that would have applied between unrelated parties.

The minimum spreads accepted by the Commissioner of income tax are as follows:

Based on these spreads, effective tax on back-to-back loan transactions entered into by Cypriot companies could be as low as 0.0125%.

Additionally, any foreign exchange differences (either realised or unrealised) should neither increase nor decrease the taxable result.

For non interest-bearing loans, the minimum acceptable spread is 0.35% irrespective of the amount of the loan.

Easily met conditions regarding the above spreads

The spreads outlined above apply in cases where a Cypriot company borrows from a related party and, within a period of six months, uses the funds to finance a loan to another related party. Funds borrowed and lent may be interest-bearing or interest-free.

The minimum acceptable spreads are calculated after the deduction of expenses directly or indirectly attributable to the relevant financing transactions – they represent net spreads.

Companies drawing one loan to finance a number of loans receivable, as well as companies drawing a number of loans to finance a single loan receivable, may also apply the minimum spreads to such transactions. Nevertheless, each loan or financing transaction entered into by a Cypriot company should be viewed separately for the application of the relevant spreads. Therefore, any companies entering into multiple back-to-back loans may not view such loans in aggregate for the purpose of determining the minimum acceptable spread.

The spreads specified above are also applicable in the case where a Cypriot company obtains a loan from a bank (provided such a loan is guaranteed by other companies within the same group), and uses funds obtained to finance loans to related parties.

The minimum acceptable spreads may also apply in cases where credit instruments other than loans are used (subject to pre-approval – see below).

Certainty obtained through rulings

One of the most positive developments regarding the tax authorities' position on back-to-back financing is the possibility of obtaining advance rulings from the Commissioner of Income Tax regarding minimum acceptable spreads.

Rulings provide an excellent tool to companies wishing to obtain certainty regarding the spreads applicable to any back-to-back financing transactions entered into (especially in cases involving sizeable transactions or grey areas, such as the use of financial instruments other than loans).

Opportunities arising

Recent developments not only offer the opportunity to investors for additional structuring of back-to-back transactions through Cyprus, but they also make it possible for existing Cypriot companies to further enhance the efficiency of any back-to-back transactions already in place. By reviewing their current financing arrangements and identifying any possibilities for improvement of their Cypriot tax position, taxpayers may make full use of the benefits available to them regarding related party financing.

Natasha Pilides (natasha.pilides@cy.pwc.com) is a manager, direct tax services with PwC in Cyprus